Katrina and the Waves

The giant waves Hurricane Katrina has sent through the global financial
markets - like roads less traveled - will make all the difference for the
remainder of 2005.

Energy prices are near record highs, the yield curve recently inverted (2Y
vs. 3Y), and the Federal Reserve Board may be done tightening sooner
rather than later. Welcome to the aftermath of Katrina: the devastating Hurricane
that left death, human suffering, and chaotic financial markets in its path.

Notwithstanding how important energy prices and interest rates are to the
US and credit drenched global economy, one of the biggest topics following
Katrina is the price of gold. After dropping early last week the price of gold
zoomed ahead by more than $12 an ounce for the three days ended last Friday
(October contract). The culprit behind gold's resurgence was the falling dollar.

It goes without saying that Katrina has instigated a period of uncertainty.
But whether not rising energy prices will cause a recession or falling US interest
rates will add fuel to the already hot housing market is unknown. What is known
is that any further rally in gold - to levels not seen in 16+ years - could
quickly act to restore the dollar crisis fears that were running amuck in late
2004.

Katrina Not Found In Any Textbook

While Northern Trust Director of Economic Research, Paul Kasriel, is correct
in that 'Katrina
Had No Silver Lining', Mr. Kasriel's intellectually rigid conclusions fail
to grasp how important Katrina could be on an international scale. Moreover,
what Mr. Kasriel ignores when he calmly states that because of Katrina 'There
will be a change in the composition of spending, not in its total', is that
a major disaster can ignite an incredible chain of events. As an example, 9/11
will suffice:

Following 9/11 stocks crashed, the Fed quickened its pace of interest rate
cuts, companies introduced new incentives to try and spur sales, and consumers
went from saving more of their money (in June, July, August, and September
2001) to spending all of their money and then some in October 2001. In other
words, 9/11 impacted financial markets, policy decisions, and business/consumer
spending/confidence trends.

Whether or not Katrina proves to be the type of disaster that stalls but then
kick starts the US economy* remains to be seen. Regardless, with energy prices
near record highs, bond prices and Philadelphia Fed boss, Santomero, suggesting
that the Fed may soon end its campaign of measured rate increases, and President
Bush having released oil from the Strategic Petroleum Reserve, it is clear
that Katrina has already had a deep impact on the financial markets and policy
decisions.

In short, from a macro perspective Katrina is not about the destruction of
'real wealth' and the 'postponement of current consumption' on a localized
scale. Rather, Katrina is all about setting into motion a chain of events that
will lead to gains or losses in 'paper wealth' and the threat that energy expenditures
will cannibalize consumption on a global scale. Unfortunately, given that the
effects of Katrina have the potential to initiate self-fulfilling prophesies
(i.e. as businesses/consumers start to think that a slowdown is near this alone
brings about a slowdown), no textbook can answer what total impact Katrina
will have until after the fact.

* The policy decisions in response to 9/11 aided the quick recovery in the
American economy rather than the tragedy itself.

Commercial Facts & Go Figure

After holding a record net short position (as a % of open interest) in
each of the two weeks ended August 23, the commercials covered a massive 49,257
contracts (futures & options) in the latest COT report. Since the COT report
was compiled on August 30 the price of gold has rallied strongly, and it is
almost certain that the commercials have begun accumulating short contracts
again. Accordingly, and to reiterate last
weeks sentiments : 'the commercials are having to exert more energy
to curtail the price of gold with each rally...This suggests that the commercials
are closer to losing control of the market than ever before.'

Since 2002 no major move higher in gold has started, much less been sustained,
when the commercials were as short (as a % of OI) as they were last Tuesday
(using futures & options). This, combined with the fact that gold is entering
a seasonal strong trading period, could mean that the end to commercial rigging
is near. And yet gold is near a key price level that the commercials have proven
increasingly keen on protecting. Uncertainty in the gold market...Go figure.

Conclusions

The hope is that those still suffering because of Katrina will be attended
to, and that the prolonged period of rebuilding will proceed quickly and smoothly.
Similarly, the hope is that the US financial markets will retain their integrity;
that Katrina's negative impact on US energy prices/infrastructure is temporary;
that the upcoming meeting between the Fed and banks relating to derivatives
goes smoothly; that the price of gold does not skyrocket as the US dollar sinks.
Yet while the hope is for calm the reality is that the death toll from Katrina
is likely to be staggering, and a major financial crisis is always around the
corner.

Keeping in mind that the seemingly unquenchable appetite for US dollars is
what keeps the global economy afloat, that Katrina runs the risk of curbing
growth via an energy crisis is worrisome. However, that gold is threatening
to unhinge from its traditional role as a hedge against inflation and become
a legitimate currency choice for central bankers and safety minded investors
is ominous. If gold zooms to new highs the commercials risk, at minimum, a
mad rush to cover their paper short positions. At the maximum, the commercials
would start defaulting, which could lead to an even further run on gold.

History is riddled with instances when fiat money has lost out to gold (unfortunately
with the history of Greenspan hogging the limelight the history of gold as
the safest of all investments rarely sees the light of day). Skyrocketing gold
is a significantly more menacing prospect than $100 oil or a crashing US housing
market. A run to gold equals a run out of the US dollar. Look out if this happens.

In short, despite the fact that the price of gold is overextended unless the
dollar's demise is near, the only conclusion is to own some gold and forget
about it. There will be another financial storm.